NU Online News Service, Sept. 25, 1:35 p.m.EDT

NATIONAL HARBOR, MD-The nation's insurance regulatorsafter a hearing examining the flawed performance of the ratingagencies left unresolved what their next move will be.

The session was held at the Fall National Meeting of theNational Association of Insurance Commissioners which employsrating agency evaluations to determine insurers' risk-based capitalrequirements.

During the proceedings the regulators discussed whether ratingagencies' failures leading up to the nation's credit crisis werecaused by conflicts of interest related to the agencies' for-profitbusiness model or misunderstanding the risks associated with thestructured securities they were rating.

Commissioners at the NAIC's Rating Agency Insurance WorkingGroup, agreed their level of reliance on rating agencies needs tobe re-examined, but left unclear what alternatives mightemerge.

Plans for the NAIC to take on rating responsibilities itselfremain on the table, though Chris Evangel, managing director of theNAIC Securities Valuation Office cited in testimony some logisticaldifficulties with that strategy.

Still, commissioners said for now, every option will beconsidered. "We owe it to consumers to be thoughtful anddeliberate," Connecticut Commissioner Tom Sullivan said.

As for where rating agencies went wrong in the credit crisis,commissioners disagreed.

The rating agencies themselves admitted they erred in ratingresidential mortgage backed securities, but said that was theexception to a long history of success.

Agency representatives said they have taken steps in the areasof governance, compliance, and an institutional rotation ofanalysts to guard against future failures. They also charged thatthe information they provide has been misused, or even used with adegree of naivety, by those who had come to rely on theirservices.

Jerome Fons, principal with Fons Risk Solutions, a NewYork-based credit risk consulting firm who is also a formeremployee of Moody's, suggested in testimony that the ratingagencies' for-profit model creates a conflict of interest thatcontributed to the current crisis. He said rating agencies "tradedtheir reputation for profits."

David Marks, executive vice president and chief investmentofficer of Madison, Wis.-based CUNA mutual group said he does notbelieve it was the for-profit model, but rather a lack ofunderstanding of the types of structured securities being ratedthat created the rating agencies' missteps.

Commissioners were divided. Commissioner Sullivan said he seesinherent conflicts in how rating agencies operate and said thefor-profit model, combined with the pressure within rating agenciesto be the first to upgrade and first to downgrade, creates a"conflicted model" that has evolved over time and cannot be changedovernight.

"While I hear what rating agencies are saying about governanceand compliance and all those other nice things, until you changethe structural underpinnings of how they operate, I don't think youcan fundamentally change how they rate," he said.

He also challenged the notion that regulators have misused theratings, accusing the rating agencies of "double talk."

"On the one hand, they're saying you shouldn't rely so heavilyon us, and then on the other hand they're saying, 'we've beenaround for decades and our reputation is everything to us.' That tome is a little bit of double-talk," said Mr. Sullivan

New York Insurance Superintendent James Wrynn, co-chair of theRating Agency Working Group, attributed rating agencies' failuresmore to misunderstanding what it was they were rating.

He said regulators will look at the issuer pay model of therating agencies, "but I wouldn't say that was the primary cause ofthe problem. I think it's more the nature and combination offactors that converged at once."

Superintendent Wrynn noted the "inability to see what was goingon with the underlying assets of these structured securities."

Regarding future use of rating agencies, he said he still seesthem as a tool, just not the only tool. "There really wasn't anissue with the rating agencies until 2000," when issues such asWorldcom arose, Superintendent Wrynn said. The telecommunicationsgiant went bankrupt after an accounting scandal.

Mr. Wrynn said that rating agencies will have to work to restorethe public's confidence.

Illinois Insurance Director Michael McRaith, co-chair of theRating Agency Working Group, said he was unsure whether the problemrested with the rating agencies' for-profit model ormisunderstanding the structured securities they were rating.

He said rating agency representatives were not forthcoming withtheir responses.

"It's fair to say that as regulators we were frustrated by theexplanation from the rating agencies in response to that question,"Director McRaith said.

"I think it's fair to assume, because it wasn't said, that itwas a failure of methodology, it was a failure of leadership andgovernance, and ultimately it was a failure to acknowledge what washappening in the world." He noted that economists and others raisedred flags about residential mortgage backed securities well beforerating agencies took any action.

"There was not a lot of fact-based comment about what happenedand how we got here," he said. "It was disappointing not to hearthe rating agencies offer more reflection on their failures."

As for next steps on how regulators should use ratings to helpensure the solvency of regulated entities, testimony was given on arange of options that included establishing an independent,non-profit rating entity that would be funded by insurancecompanies, and promoting more competition among rating agencies bybreaking the virtual monopoly of the "big three" – Standard &Poor's, Moody's and Fitch.

Director McRaith asked multiple witnesses how much weightregulators should give to ratings from the big three.

Matt Richardson, Charles E. Simon professor of financialeconomics and director, Salomon Center, New York University saidrating agency figures have value as long as their model is fixedfirst.

He said the models are imprecise now because of the complexityof the products they are modeling. These products are moresensitive to the initial values used in the models, he said, anddifferent input at the outset will cause wide variety in theresults.

Several who testified noted the difficulty in effectively ratingnewer structured securities that emerged in the marketplace asopposed to corporate debt.

Mr. Richardson also said rating agencies do not model some ofthe information regulators are looking for. Revised models canmeasure default risk, he said, but as of now they cannot modelliquidity risk and market risk.

Director McRaith said interested parties have until Oct. 7 tosubmit comments before regulators make a decision on how to moveforward.